Get ready for "a much lower iron ore price". That was the blunt message from the chief financial officer of BHP Billiton this week. Speaking at the Australian Financial Review Business Summit, Peter Beaven said the "fundamentals point to a softening" in the iron ore market, pointing to a lift in supply and the waning effect of China's economic stimulus measures.
His words come at a delicate moment for mining investors. It was a massive 2016 for shareholders in the major iron ore producers, BHP, Rio Tinto and, especially, Fortescue, as the price of the bulk commodity surged 80 per cent. That exuberance extended into 2017, with iron ore reaching almost $US95 a tonne in February and the diggers producing the kind of results that most company bosses can only dream about.
But in recent weeks there have been signs of tarnish on the golden mining bull. The price of the key bulk commodity has quietly dropped from just shy of $US95/tonne to closer to $US85, a pretty hefty fall of 9 per cent. Shareholders are selling out. BHP is off 15 per cent since late-January highs. Rio shares have dropped by a similar margin over the past couple of weeks, and Fortescue 12 per cent.
Time to cash out your chips? If you were clever or lucky enough to have a big exposure to the miners at the beginning of last year, then you would be tempted and probably justified in taking some profits, as long as you had a better place to invest that cash. But strategists remain upbeat about the sector and continue to prefer mining stocks. Which means for those who are weighing up whether it's too late to get on board, there are reasons to be optimistic.
First off, you need to recognise the recent selling in mining stocks came after a strong January. A quirk of the miners is that analysts tend to reassess earnings forecasts during that month's quarterly reporting season, rather than the reporting season proper that follows, JP Morgan head of Australian equity research Jason Steed says. As such, share prices followed those upward revisions rather than the actual earnings announcements. For the calendar year to date, the metals and mining sector is still up.
There is also sentiment at play. Morgan Stanley analysts observe "meaningful reluctance" among investors to add more weight to the broad materials space. Not only that, it's also likely that people are taking profits. For example, Steed's team at JP Morgan retains materials as the biggest "overweight" in its portfolio, but have "scaled back" its positioning "following a strong run". It's reasonable to assume that many institutional investors are doing something similar.
"No doubt there's a bit of fatigue," Steed says, pointing out that the mining sector has only dropped two in the past 12 months.
So what about the prospects of a "much lower" iron ore price? Well, it obviously depends on how "much lower". A typical comment from fund managers' February report runs: "It is certain that iron ore prices will retrace from current levels north of $US90". Each commodity has its own drivers — copper's fundamentals are arguably better given the big supply disruptions happening right now — but we'll focus on Australia's biggest export here, given its outsized importance to the three stocks in question.
ANZ senior commodity strategist Daniel Hynes is not surprised to hear BHP's Beaven talking down the iron ore price. The message from the big miners over the reporting season was to expect a tonne of iron ore to fetch $US50-60 a tonne in the short term, Hynes notes, and that "the market's expectations are still set around that level as well".
"I suspect prices are going to hold up significantly better than the market is assuming," Hynes adds.
"The [Chinese] National People's Congress came out again with some key targets around steel capacity closures again for 2017," he says. "They definitely look hell-bent on eradicating that overcapacity, which ultimately benefits the steel and iron ore market." Chinese policymakers also made all the right noises around maintaining economic growth ahead of the major party congress later this year.
Hynes says the cautious commodity price outlook from the miners is "the natural position for them to have".
"Obviously they have come out of a near-death experience, and you're not going to see them suddenly over-exuberant about the price and the outlook," he says.
"That seems to be a fairly logical response and a responsible position to take, and in effect it actually supports the price even more over the medium term, because we are not going to see the supply response immediately you normally would given such a strong rebound in prices."
JP Morgan's Steed agrees that while mining bosses are cautious, they are not ringing the alarm bells.
"We met Rio and the other miners through reporting season, and ultimately their outlook for the major commodities, while not necessarily $US90 for iron ore, equally it's not a cataclysmic 'we are back to $US30 in six months' type of view," he says.
The crux of the argument around whether to remain exposed to the big miners, or whether to take a new position in them, comes down to expectations around their earnings and cash flows in the coming year or two.
"Based on our expectations for commodity prices, we still think the market is underestimating cash flows over the next 12 to 18 to 24 months," he says. "That's where I think things are going to stand in favour of the sector: I'm expecting upgrades."
